Chapter XIII The Basics of Bankruptcy Law for Construction Lawyers

• Library: SC Construction Law Desk Book (SCBar) (2022 Ed.)

Chapter XIII The Basics of Bankruptcy Law for Construction Lawyers

Adam J. Floyd Tara E. Nauful

A. General Information

The Bankruptcy Code (the "Code") is codified in 11 U.S.C. §§ 101 et seq.¹ There is a common misconception that bankruptcy is a creature of state law; this is incorrect. While certain debtor/creditor type proceedings may be filed in state courts (e.g., receivership actions and dissolutions), the federal courts have exclusive jurisdiction over all bankruptcy cases. And, while the various bankruptcy courts may differ in their interpretation or application of the statute in certain circumstances, the Code itself is the same in each of the 50 states and all territories of the United States.²

The Bankruptcy Code is divided into the following sections:

• General Provisions of the Code: § 101

• Case Administration: § 301

• Creditors, the Debtor, and the Estate: § 501

• Liquidation: § 701
• Bankruptcy of a Municipality: § 901

• Reorganization: § 1101

• Subchapter V

• Bankruptcy of a Family Farmer or Family Fisherman with Regular Annual Income: § 1201

• Bankruptcy of an Individual with Regular Income: § 1301

• Ancillary and Other Cross-Border Cases: § 1501

B. The Chapters

What "chapter" or type of bankruptcy a proposed debtor can file is set forth in § 109. If an individual or entity³ attempts to file a case improperly, or files the case under the wrong chapter of the Code, the case will not be permitted to proceed. The following is a summary of the chapters of bankruptcy available under the Code:

1. Chapter 7

The purpose of a Chapter 7 is liquidation. The general rule of thumb is this: if debts exceed assets, then a Chapter 7 may be the solution. A Chapter 7 can be filed by virtually anyone or any "thing"⁴ not prohibited by § 109(b).⁵ Upon the filing of every Chapter 7 petition, a Chapter 7 trustee is appointed to investigate the financial affairs of the debtor and to determine whether there are any assets that can be liquidated to pay creditors of the debtor or whether there are any claims against third parties that can be pursued to generate revenue for distribution to creditors.⁶With the exception of secured creditors (who get their collateral back), whether there will be a distribution to creditors in a Chapter 7 depends upon what the Chapter 7 trustee's investigation yields. More often than not, unsecured creditors in a Chapter 7 receive nothing, and most Chapter 7 cases are closed after 90 to 120 days.

If assets are found, the Chapter 7 trustee liquidates the assets and, after paying the costs of the liquidation (including the Chapter 7 trustee's commission), the net proceeds are distributed to the debtor's creditors in their order of priority.⁷The Chapter 7 trustee also has the authority to bring "avoidance actions" to recover assets for the benefit of creditors of the estate,⁸ and the authority to investigate claims against the debtor that may impact the debtor's ability to receive a Chapter 7 discharge.⁹

If no one objects, an individual who files Chapter 7 will receive a "discharge" of his debts.¹⁰ In simplest terms, this means that the person is no longer personally liable for debts that arose pre-petition.¹¹ After the discharge order is entered and the bankruptcy case is closed, creditors are prohibited from attempting to collect their pre-petition debts from the debtor.¹²

2. Chapter 11

A Chapter 11 can be filed by virtually anyone or any "thing."¹³ An easy way to distinguish Chapter 11 from the other chapters is to remember that it is available to, and most often utilized by, businesses that want to reorganize or want to liquidate assets and cease operations but want to remain in control of the liquidation process. Chapter 11 is also available for very wealthy individuals who are not eligible to be debtors under Chapter 13.¹⁴ A Chapter 11 reorganization or liquidation is accomplished via a Chapter 11 plan.

As a general matter, when a Chapter 11 case is filed, the debtor remains in possession of all assets of the bankruptcy estate and is referred to as the "debtor-in-possession."¹⁵ In this role, the debtor-in-possession has the duties of a trustee and, as such, is a fiduciary to all creditors of the bankruptcy estate.¹⁶ Like all fiduciaries, the debtor-in-possession owes creditors the highest duty of care and loyalty, and is tasked with maximizing the recovery to its creditors through the pursuit of preference and other avoidance and/or recovery actions. Unless there is evidence that the debtor-in-possession cannot be trusted, or the creditors do not have confidence in the debtor's abilities to administer the estate assets, a Chapter 11 debtor will remain in possession and control of its assets and administer them itself by proposing, confirming, and consummating a Chapter 11 plan.

3. Subchapter V

Signed into law in August 2019, with an effective date of February 19, 2020, the Small Business Reorganization Act ("SBRA"), created a new subchapter within Chapter 11, known colloquially as Subchapter V. The purpose of Subchapter V was to provide relief to qualifying debtors who, in the past, lacked sufficient financial resources to file a Chapter 11 case, but needed the relief that a bankruptcy petition would offer. Subchapter V is available to only a small business debtor engaged in commercial or business activities, with non-contingent, secured and unsecured debt of no more than $2,725,625.¹⁷

The first major category of changes in Subchapter V involve which parties control the path of the bankruptcy case. Generally, in Chapter 11, the debtor retains control of the operation of the business, has the first right to file a plan, and, upon confirmation, makes distributions to creditors. Although there is a mechanism to replace the debtor and debtor's management with a trustee, this happens rarely. If it does happen, the trustee takes complete control of the bankruptcy case, including the filing of a bankruptcy plan and the operation of the business.

Different from a traditional Chapter 11, Subchapter V provides for the automatic appointment of a trustee. However, the role of this trustee is not as expansive as a normal appointed Chapter 11 trustee: the debtor remains in possession of its assets and operates the business. The Subchapter V trustee's role is more closely akin to a Chapter 12 or 13 trustee who primarily collects funds, disburses payments to creditors, and monitors the debtor's progress. Like in Chapter 11, the debtor can be removed from having control over the business for "fraud, dishonesty, incompetence, or gross mismanagement." If this happens, the trustee takes control of the operation of the business and existing management is out.

The final amendment relevant to this category of changes is who may file a bankruptcy plan and when a plan must be filed. In a Chapter 11 case, the debtor initially has the exclusive right to file a plan, but, upon expiration of the exclusivity period, any party in interest may file a plan. In a case under Subchapter V, only the debtor may file a plan, which is, again, similar to a Chapter 12 or 13 case.

Additionally, in a typical Chapter 11 case, there is no statutory deadline within which a Chapter 11 debtor must file the plan. Subchapter V will substantially expedite this timeline by requiring that a debtor file the plan no later than 90 days from the petition date.

The second category of changes involves fees and professional compensation. Generally speaking, in all bankruptcies, an attorney is not allowed to file a bankruptcy on behalf of a debtor that has unpaid attorney's fees which have not been waived by the attorney. Subchapter V allows an attorney to represent a debtor filing under Subchapter V so long as that attorney is owed no more than $10,000 as of the petition date.

Another difference between Chapter 11 and Subchapter V are fees. Chapter 11 debtors are generally required to pay a quarterly fee to the United States Trustee (the "UST"). These fees are calculated based on a percentage of the total distributions made by the debtor during the quarter. Subchapter V exempts debtors from the requirement of paying the UST quarterly fees. Small business debtors, who frequently are cash-strapped to the point that they cannot afford either the large retainers required for a Chapter 11 case or the quarterly fees, will greatly benefit from these provisions.

The final category of differences relates to the bankruptcy plan itself. Chapter 11 debtors are required to file a "disclosure statement" with the bankruptcy plan. The purpose of the disclosure statement is to facilitate creditors' understanding of the bankruptcy plan, and ultimately whether the creditor will accept or reject the plan. The disclosure statement itself can be very lengthy, as it contains detailed historical operational and financial information; a summary of the Chapter 11 case; an analysis explaining why creditors will fare better in a Chapter 11 reorganization rather than a liquidation, and future projections of the debtor's business to show the debtor's ability to make the payments required under the plan. After the disclosure statement is served on all creditors, the court must hold a hearing to approve the disclosure statement for the Chapter 11 case towards the ultimate goal of confirming the bankruptcy plan.

The creation, serving, and approval of the disclosure statement is expensive and time consuming. Thus, in 2005, amendments to the bankruptcy code allowed the court to determine that the disclosure statement is not necessary for small business cases, and to require, instead, that information be provided in the plan. Subchapter V takes this a step further and instead presumes a disclosure statement is not necessary unless the court orders otherwise and directs that all information that might be in a disclosure statement be included in the plan. This amendment will allow the debtor to save significant time and money on professional fees and expenses.

The final, and...